The November 2007 issue of Kiplinger's has a great article from James K. Glassman called “The Upside of Risk”. Glassman's explanation of market risk is wonderful. Normally, I'd post an excerpt from the online version of the article and then point you to it, but I can't find this piece anywhere on the web. Instead, I'll post a longer excerpt than normal.

Imagine a world in which stock investments performed the same year after year. A stock would be like a certificate of deposit. It would have no volatility — except for the effects of inflation — but it wouldn't put much money in your pocket, either. Stocks have returned an annual average of more than 10% over the past 80 years because they are volatile. To put it another way: A higher return is your reward for investing in a riskier asset.

You have to work to make money in the stock market. To a small degree, the work entails picking good companies or good mutual funds. But most of the work is enduring the anxiety and fear of owning something that could be worth a good deal less tomorrow than it is today. The challenge is to hang on to good firms through thick and thin.

For that reason, I have little patience for investors who whine about the volatility of the Dow or the Nasdaq. If you're risk-averse, you can put your money in plenty of places, including Treasury bills, short-term notes and money-market funds. But if you want higher returns, you have to accept the thrills and spills that accompany them.

[…]

Again, imagine a world in which a company such as Johnson & Johnson (symbol JNJ) traded every day at nearly the same price, slowly inching up a few percentage points a year. As an investor, your ride would be smooth, but you would never have the opportunity to buy a bargain. Over the past four years, however, the stock of even this relatively stable company has bounced between about $45 and about $67. All that time, J&J has been the same company, doing business in the same global economy. But investor expectations — influenced by the effects of enthusiasm and fear — have at times boosted the stock and other times depressed it.

If you are an investor who loves the company, and you want to own it for the long term (as you should), then you should be a buyer when volatility drives J&J's price down.

[…]

In general, the volatility of the U.S. stock market has two characteristics you can exploit. The first is that the market is less volatile over longer periods. For example, over the course of just five trading days last August, the S&P fell 90 points, or 6.3%. But for the entire month of August, the S&P was actually up by 1.3%… The longer you hold on to stocks, the more volatility declines. Over 15-year periods, stocks [have] scored positive returns every time.

[…]

The second way to exploit volatility is to dampen it through diversification… True, by owning a lot of stocks (or an index fund or a broad mutual fund), you limit your upside. But for most investors, it's a good trade-off. If history is a guide, you'll get double-digit returns on average, and volatility will be manageable.

As I've said before, historically the stock market has provided solid returns over the long-term. It does have a lot of short-term volatility, though. If this volatility bothers you, you ought to keep your money in safer investments until you've had a chance to educate yourself on why “risk” isn't always a bad thing.

In 2006, J.D. founded Get Rich Slowly to document his quest to get out of debt. Over time, he learned how to save and how to invest. Today, he's managed to reach early retirement! He wants to help you master your money — and your life. No scams. No gimmicks. Just smart money advice to help you reach your goals.

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There are 11 reader responses to "The Upside of Risk: Why Market Volatility is a Good Thing".

briansays

My second-favorite thing about finance (other than enjoying money :-) is that there is an investment strategy available for every level of risk. On one extreme, you have the cash under your mattress that has 0% volatility but no gain (and a loss if you count inflation). Then comes Treasury Bills and money market for low-risk. Stocks are moderate, day-trading has more. And if you want the quickest, highest-risk “investment”, you can gamble. 100% gain or 100% loss in 30 seconds.

It is up to each person to decide what his or her own comfort level is, and invest accordingly. I agree with the author; don’t whine about the system you are investing in, just change your investment.

Patience is a key character trait we all need to cultivate if we want to invest in stocks. But most people are also fond of drama and that often overrides it as we get caught up in the moment, whether that’s getting hyped up over a strong upswing or freaking out over the dips.

“All that time, J&J has been the same company, doing business in the same global economy. But investor expectations – influenced by the effects of enthusiasm and fear – have at times boosted the stock and other times depressed it.”

Please re-read that again – slowly. What it says is that the stock (market) value has no real basis in company performance anymore, but is instead influenced on by moods of the stock investors. It’s value is not based in real world! Get it? I know it’s hard to swallow that, but is as true as it was during the 2000s DOT-COM boom. It’s all a mind-thing! Why put your money in such a volatile place as a (greedy) mind is?

In periods of high market volatility, my buying strategy is to place limit orders significantly below the current stock price in order to capture a dip. I typically set my limit order price close to a support level. That’s actually how I managed to get in a few buys two days before Bernanke’s surprise 0.5% interest rate cut. So yes, I have been using volatility to my advantage.

I’ve just finished reviewing an excellent book on analyzing the market and learning the basics of charting. The book is a part of the Stikky reading series and is called Stikky Stock Charts. It is shows through a very unique teaching strategy a way of thinking about the market that strongly resembles the advice given above. You can find my review at http://www.financeisfun.wordpress.com.

Why put your money in such a volatile place as a greedy mind is, Mark? ‘Cause though individual moods fluctuate, taken all around, human nature doesn’t change. It’s one of the most reliable things there are.

The entire point of investing is attempting to gain an advantage over other people. That’s what money is, an advantage based on how badly those other people want it. If everyone invested and did equally well, it would be a zero-sum game; no one would have any more advantage over anyone else than if no one invested. Low-risk-tolerant people are simply gaining advantage over those who don’t invest at all.

“The entire point of investing is attempting to gain an advantage over other people. ”

Well that’s what it might have become to the majority of people who are in it ONLY for the profit. You know, the kind of people who won’t think twice about investing in tobacco, arms or oil industry; “if there’s money to be gained all is good”. But to me investing is never gaining an advantage over other people; that is not and never was my life philosophy. Yes, I invest to gain profit, but I invest responsibly in companies whose profit or service I support and believe in. And the profit I expect to get is based on the growth of the company I invested in, not on the market speculations.

Investing in stocks helps you escape from poor economic conditions in your home country. For the first time, citizens of China and Hong Kong can invest in U.S. equities. Very often, countries attempt to prevent capital from leaving the country by placing restrictions on foreign stock investment. SPDRS and ETF’s now offer even greater varieties of specific types of investing. Stocks are risky, yes. Consider the freedom over your financial future that you have because of it. To take that first step in investment education, I suggest joining the American Assoc. of Individual Investors at http://www.aaii.com.

First, Glassman is an idiot, the author of a book called “Dow 36,000” at the height of the bubble in 1999.

But I do agree that volatility is good for the small saver/investor (even if Glassman doesn’t understand why).

Volatility is great for dollar-cost averagers. If you’re regularly investing in a 401(k) or other plan, you’re buying more shares when they are cheap, and fewer when they are expensive. The end result is a lower average cost. I’ve been doing so with several funds over the past few years (BGEIX, RYOIX, SWTIX, SWINX, USPAX), and it’s paid off handsomely. The more volatile, the better.

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My name is J.D. Roth. I started Get Rich Slowly in 2006 to document my personal journey as I dug out of debt. Then I shared while I learned to save and invest. Twelve years later, I've managed to reach early retirement! I'm here to help you master your money — and your life. No scams. No gimmicks. Just smart money advice to help you get rich slowly. Read more.

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